The Joy of
Economics: Making Sense out of Life Robert J. Stonebraker, Winthrop
University

Demand and
Supply Applied:

Oil Prices

Genius is nothing but a great aptitude for patience.

.....George-Louis De Buffon

My elderly friend loves to reminisce about the
good old days. He tells the same stories over and over again. He
tells of watching Sammy Snead1 hitting towering drives while playing
exhibitions at his local golf course; he tells of betting $20 on Seabiscuit in
his 1938 match race with War Admiral2; and he tells of buying six
gallons of gasoline for a dollar.

Six gallons for a dollar?
During the summer of 2008 I paid
$4.36 a gallon while vacationing in Montana, but in January 2015 I paid $1.92 in
South Carolina. How could this happen? How can oil prices skyrocket
at one point and then plunge back to earth at another? Some want to
blame the forces of evil, but economists prefer explanations based on
demand and supply.

Erratic gasoline prices are nothing new. It's
all old hat to those of us with enough gray hair to remember the energy crisis
of the 1970's. Prices climbed rapidly in the 1970's, soaring from
about $3 a barrel in early 1973 to over $35 a barrel in 1980. They then
took a long slide through the 1980's and 90's, falling to almost $10 a barrel in
1998 before rising again over the last decade, diving back and then spiking
again. If we adjust these prices for inflation3
we get an even more interesting
perspective. Look at the chart below. It traces the price of a
barrel of oil over the last 50 years in terms of 2012 prices. In this case, the price increases of the
1970's look remarkably similar to those of the 2000's. And wild price
fluctuations, even when adjusted for inflation,
have been the rule.

Elasticity and prices

While these price changes have been
controversial, they are the inevitable results of shifts in demand and supply.
First, we need some background information. Both the demand and supply of
oil are
relatively inelastic in the short run:
changes in price have
little impact on either the quantity demanded or the quantity supplied. When oil prices rise
we spend considerable time and energy
complaining but, at least in the short run, spend almost no effort in trying to adjust our habits to consume less.
Similarly changes in price do little to spur new supplies in the short run. Exploring for,
drilling, and bringing new sources on-line can take many years. Since the
quantities demanded and supplied change very little as prices rise and fall,
both curves are relatively vertical as shown below:

Because quantities are relatively
fixed in the short run, any shifts in demand or supply will cause large changes
in prices. For example, suppose that supply falls. The decreased supply
creates a temporary shortage that will begin to drive up price. If demand is elastic,
only a small increase in price will be needed to get consumers to cut purchases
enough to meet the new reduced output. However, if demand is inelastic, it will
take a much
larger price increase to generate the needed cut in quantity
demanded. You want more graphs, don't you?

The graph
on the left below illustrates the elastic
demand case. The demand curve is relatively flat and the drop in supply (from S
to S') causes only a small increase in price (from P0 to P1).
However, if the demand curve is less elastic or more vertical (as in the graph on the right),
the same cut in supply causes a much larger increase in price.

Do you have the concept? When curves are
elastic, shifts in demand and supply cause only small changes in price, but when
curves are inelastic, those same shifts cause much larger price changes.

Apply this to oil markets. For many years
members of the Organization of Petroleum Exporting Countries (OPEC)
controlled most of the world's oil market.4 In the early 1970's,
partly reacting to political turmoil in the Mideast, OPEC oil ministers voted
to deliberately cut production. As illustrated above, this shifted the supply
curve for oil to the left and drove up prices. Because demand was inelastic, the
price increase was significant. The higher prices OPEC countries received more than offset the lower sales and their
oil revenues rose rapidly. In 1979 a bitter war between long-time enemies Iran and Iraq
shut down more oil fields and caused additional price increases.

Wait?

Much weeping and gnashing of
teeth in non-OPEC countries ensued and, in the wake of the media hysteria that
followed, economists were thrust into the national limelight. How could this
energy disaster be fixed? What should be done? Never very good at giving
answers that people or politicians want to hear, most economists replied: "Don't
do anything; just wait."

The answer was both unpopular and correct. Demand and
supply are far more elastic in the long run than in the short run. After
oil prices
rose, firms began shifting to less energy-intensive ways of manufacturing goods
and services. Similarly, consumers started to conserve as well. They insulated
homes heated by oil furnaces and shifted to alternative energy sources. More
importantly, they began buying different types of cars. They gradually ditched
the gas guzzlers they purchased in 1971 when fuel prices were not an issue and
bought
smaller, more fuel efficient vehicles. As we shifted from cars getting 12 miles
per gallon to ones getting 28 miles per gallon, the demand for gasoline (and its
price) began to fall.

Supplies adjusted as well. The increased
prices of the 1970's unleashed a frenzy of successful new exploration and
drilling. New oil fields came on line all over the world in places such as
Mexico, Russia and the North Sea. Fields that were not profitable to develop
when oil was $4 per barrel proved to be veritable bonanzas at $35 per barrel.
The combination of conservation and new supplies gradually drove prices
down until, in inflation-adjusted terms, they returned to 1972 levels.5

Regrettably it did not last. Prices began
to inch up again after the turn of the century and recently have climbed well above
historic levels. Why? What happened? Was it still demand and supply?

It
was.
First, demands rose rapidly during the first decade of the 21st century. Consumers, lulled by low prices, abandoned their fuel-efficient Hondas
and Toyotas for behemoth trucks, vans, and SUVs. Perhaps more importantly,
strong economic growth in countries such as China and India created more
factories and more cars that need more oil to run them. Supplies also have
suffered. During the U.S. invasion many Iraqi oil fields were destroyed and
production there remains well below pre-war levels. Production in other
countries also has been disrupted, most recently when militant attacks in early
2008 closed major oil fields in Nigeria. Rising tensions in the Mideast added to the
problems. Fearing that current pressures might rekindle armed conflict between
Iran and Iraq and cause further cuts in supply, many oil brokers increased
purchases in an attempt to lock in supplies at current prices. Not
surprisingly, this speculative buying increased demand and drove up prices still
more.

Do you see it? Increased
demand from U.S. motorists, from other countries, and from speculators worried
about even higher prices in the future, coupled with supply cuts in Iraq and
Nigeria caused oil prices to increase. However, by late 2008 problems in U.S. mortgage lending set off a
crisis in global financial markets that led to a global economic slowdown.
The slowdown, in turn, caused a drop in demand for oil and began pushing the
price of oil back down. [Can you picture how a shift in the demand curve can do
this?] Once prices began to fall, speculators who had purchased large
volumes of oil expecting to be able to resell at a higher future prices, began
to lose money rapidly. To cut their losses they dumped their supplies on
the market hoping to unload them quickly before prices fell further. Of
course, this increased market supply and drove down prices even more rapidly.
Oil prices that peaked above $140 per barrel in July 2008 had fallen to a mere
$40 by December. Waiting worked.

Of course it did not last.
Unrest in the Middle East, accentuated by popular uprisings in Tunisia, Egypt,
Libya, Yemen, Bahrain and Syria refueled speculative fears that lengthy
civil wars across the region would destroy oil fields and shut down pipelines. As firms rushed to
lock in supplies, demand surged and prices soared back above $100 per barrel.
By May 2011 domestic gasoline prices once again approached $4.00 per gallon.
Then in 2014 prices plummeted once again. Economic slowdowns in China and
Europe caused part of the drop, but increased supplies, largely the result of
new technologies being used in the U.S. and Canada, were the primary drivers.6
The price cuts have been a windfall to consumers across the world, but are
wreaking havoc in countries such as Russia and Iran that rely on oil exports to
prop up their domestic economies.

What now? Will the current low
prices continue? Probably not. Given the
political instability in many major oil-exporting nations, coupled with
inelastic demands and supplies in the short run, the roller coaster price rides
of recent decades are likely to continue.

Lower prices?

Some argue that the
government should step in and mandate permanently lower prices. Such schemes pander to
populist preconceptions, but make little economic sense. Are you ready for one
last graph? Suppose the government decides to lower gasoline prices by decree
and forbids firms from charging any price higher than P1 in the graph
below. In economic jargon, P1 becomes a ceiling price. Consumers
immediately react to the lower price by increasing their quantity demanded from
Q0 to Q2. However firms react in the opposite way. Stuck
with a lower price they reduce their quantity supplied from Q0 to Q1
and a shortage results. The quantity demanded (Q2) now exceeds the quantity supplied
(Q1).

Some consumers
do get gasoline for a lower price, but others get no gasoline at all. Since output has been
cut from Q0
to Q1 there is less gasoline to go around. It simply is not
profitable to produce as much at the lower price. Who gets the gasoline and who
does not? In a free market consumers would compete for the scarce gasoline by
offering higher prices; those willing to pay the most would get the gasoline.
However, with a price ceiling in effect, paying higher prices is illegal. Firms
and consumers must find a different way to decide who gets the gas and who does
not.

The traditional alternative is
first-come-first-served. Those who get to the station first get the limited
supplies; those at the end of the line do not. The gas is gone by the time they
get to the pump. But think about this. If the product goes to those in line
first, what will you do? That's right. You'll try to be first in line.
Unfortunately, everyone else will be doing the same thing. The result will be
long lines (and short tempers) at the pump. Those who "win" and get to the
pumps first will get their gas at a lower price, but they must pay a higher price in
terms of time and energy spent waiting in line. Those at the end of the line
lose twice. They lose by having to wait in line and lose again by seeing the
gas run out before they get to the pump.

Could this actually happen?
Readers who remember the 1970's know that it could and that it did. To "protect"
consumers, we did slap price ceilings on oil and gas products, only to be
slapped back with the long lines and shortages described above. It was ugly.

If prices do soar up again, most economists
will offer the same
advice they gave in the past: wait. High prices are painful, but they
serve a very real economic purpose; they discourage consumers from using a
scarce resource and encourage suppliers to produce more. In the long run higher prices will
cause consumers to shift back to more fuel-efficient cars and adopt other
measures of conservation. In the long run higher prices will cause firms to
increase exploration and drilling to bring more supplies to the market. And,
more importantly, in the long run higher oil prices will create incentives to
develop cleaner and more renewable energy sources. OPEC oil ministers understand
this quite well. Saudi officials often have pushed for moderation in oil
prices precisely because they fear prices that rise too much too quickly will
drive consuming nations to get serious about conservation and alternative energy
programs. They understand that this could destroy the long-run market for
oil and, in turn, damage their future economic growth.

Despite their bad rap, rocketing
gasoline prices actually can have very beneficial side effects. Evidence
suggests that the low gas prices of the past caused an increase in
driving which, in turn, led to more pollution, more traffic-related deaths and more obesity.7
As the pinch of higher pump prices causes us to cut back our highway mileage,
the likely result could be a cleaner, safer and leaner America. Calls for patience may not
win elections, but may be sensible policy nonetheless.

____________________

Notes:

1. Sam Snead
was the Tiger Woods of his day and still holds the record for most lifetime wins
on the PGA tour.

2. Termed the most famous match race in history, Seabiscuit pulled away
from heavily favored War Admiral in the stretch. You can
view a video of the race on the web. Seabiscuit's life also inspired an acclaimed 2003 movie starring Jeff Bridges and
Toby Maguire.

3. A later chapter will discuss how such calculations can be made. As
an example, suppose that average prices doubled from 1985 to 2008 (which is
approximately true). If the 1985 price was $14, it would be twice as high (or
$28) when restated in terms of 2008 prices.

5. Readers familiar with cartels and game theory will recognize that
this and subsequent explanations, though largely true, are simplified.

6. "Fracking" technologies in the U.S.
have enabled drillers to extract huge volumes oil and natural gas from
previously uneconomic sources and led to energy booms across the Dakotas and the
through much of Appalachia. Similarly, new technologies have allowed
Canadians to extract oil from tar sands and shale formations.